The Tax Problem at the Heart of China’s “GDPism”

When China’s policymakers convene their Central Economic Work Meeting next week, all eyes will be on whether the conclave sets a target for GDP growth in 2018. During his speech to the Communist Party Congress in October, Xi didn’t mention a target, which an official later explained was a deliberate signal that China needs to focus on the quality rather than pace of growth. There’s since been speculation that Xi might do away with the target entirely.

In recent years, the target has been seen as a roadblock to reform, but it wasn’t always that way. During the early years of the Hu-Wen era, when the economy was still absorbing workers made redundant by state sector reform, fast economic growth was deemed necessary to maintain sufficient employment, and the GDP target was set accordingly. That’s no longer the case. Instead, the target—which is invariably set at levels that some parts of the country find extremely difficult to achieve, but nevertheless feel compelled to surpass—has given rise to what is sometimes called “GDP-ism,” whereby officials prioritize growth above all else.

The pursuit of arbitrarily high levels of growth has come at the cost of environmental degradation and heavy indebtedness. Maintaining an explicit GDP target around current levels—the 2017 target was “around 6.5%”—would likely exacerbate those problems. Consequently, getting rid of the target has the potential to be an incredibly important signal. If managed properly, it could help place growth on a more sustainable trajectory. But its impact could be limited to mere symbolism unless it’s part of a broader change.

As my colleagues Evan and Damien argued in June, local government officials are caught between a rock and a hard place. The GDP target drives them to continue stimulating growth, but at the same time Beijing touts the importance of reform, two agenda items that are often directly at odds. Faced with the soft targets of reform and the readily quantifiable growth target, they opt to prioritize growth. But getting rid of the GDP target won’t resolve that contradiction unless it is accompanied by a cultural shift at the top of the government. In other words, just because the target goes, it doesn’t mean that the political system won’t still continue to prize fast growth, and reward officials accordingly. It’s not inconceivable that an informal, unofficial target takes its place, a level of growth that ambitious mayors and governors know they need to achieve to be reasonably considered for higher office.

Certainly, there are promising signs that Xi might be willing to make a clean break from the past, with the recent closing of factories across the country on environmental grounds suggesting a shift in Beijing’s balance of priorities. Moreover, the path that Xi laid out for the Party in his speech to the Congress—one that prioritizes building a ‘better life’ for China’s citizens—would seem to be conducive to moving away from arbitrary growth targets. At the same time, however, Xi’s “Chinese Dream” and his ambitions for China to catch up with the rich world requires robust growth to continue indefinitely, which could undergird the need for fast growth, even without an explicit target.

However, even with a cultural shift at the top, we shouldn’t expect great things to flow from abolishing the GDP target. That’s because the incentives that fuel the growth-at-all-costs mentality prevalent among local government officials stretch well beyond the need to deliver a certain level of GDP. While their ability to generate economic growth contributes to their promotion prospects, it’s not the only factor. Perhaps even more important is the need to generate tax revenue in ever increasing amounts.

Technically, the performance of local officials is assessed according to a long list of metrics. Some are explicitly financial, measuring how much investment they attract into their jurisdiction and how much additional fiscal revenue they generate. Others focus on poverty reduction efforts, improvements in education, and cleaning up the environment. Not all of those goals are equally weighted. Economic development and taxes tend to take pride of place. But taxes are so important for an additional reason: they are essential to meeting the other metrics—the qualitative improvements in education, health, and the environment—upon which their political careers depend.

But China’s tax regime is heavily biased against subnational governments. China’s provinces, cities, counties, towns, and villages are responsible for about 80% of all expenditures, including health, education, and pensions, but they directly receive only half of all taxes. Beijing makes up the shortfall by remitting back at least some of the difference, but it also often pushes new responsibilities down to lower levels of government without providing adequate funding—what we might call “unfunded mandates.”

That has distorted the economy in all sorts of ways. In recent years, some local governments have pressured local firms to pay their taxes a year in advance, despite the Ministry of Finance exhorting them not to. Sometimes they top up their income by hosting forums, exhibitions, and training events and then charging local companies for the privilege of their compulsory attendance. And sometimes authorities impose arbitrary fees and fines on businesses to make up the shortfall, something else that Beijing has tried to be vigilant against. But the surest way to ensure rising tax receipts is to deliver economic growth.

That goes a long way to explaining China’s zombie problem. We typically assume that the reason local authorities keep zombie companies—unprofitable firms that are unable to service their debts—alive is in order to prevent unemployment. That’s only part of the picture. Somewhat counterintuitively, a zombie company generates tax revenue while a dead one is drag on government finances. When a state firm is closed down, the local authorities need to step in with unemployment insurance and pensions. Meanwhile, although zombies don’t make a profit, they typically continue to generate taxes. Local governments currently get to keep half of the value-added tax that gets collected on the sale of locally manufactured goods (the rest goes directly to Beijing). So, a company that’s losing money is still generating taxes for local authorities as long as it continues to make sales. In other words, a factory might not be generating enough orders to break even or repay its loans, but for local officials who draw tax revenue from sales, closing the plant means losing a chunk of fiscal revenue. Meanwhile, the cost of keeping the company alive is typically borne by the financial system.

And therein lies the heart of the problem. Even without an explicit growth target, the need to generate taxes drives local officials to use the financial system to stimulate growth beyond what would otherwise be possible. The banks not only help maintain tax revenue by keeping zombies alive. They’re instrumental in stimulating growth. And as long the economy is growing, so do government coffers. That’s a state of affairs that will persist with or without a GDP target.

Of course, when China’s economic policymakers meet on December 18, they may decide to keep the GDP target. But if they do get rid of it, it will undoubtedly be an important step toward weaning officials off the idea that they need to achieve fast economic growth at all costs. But it’s important to keep in mind that getting rid of the target marks the beginning of the process, not the end.